Simple formula to cut debt served us badly

Stephen Koukoulas

Government debt, the budget deficit and economic management are likely to dominate the remainder of the election campaign, with Opposition Leader Tony Abbott reiterating his claim that the government is on a ''spendathon'' with gross debt ''skyrocketing towards $400 billion''.

Abbott's claims come on the heels of the release on Tuesday of the Pre-Election Fiscal and Economic Outlook from Treasury and the Department of Finance. PEFO confirmed the downward revision to revenue that was contained in the government's economic statement of August 2, which increased the estimate for the budget deficit for the next few years. The PEFO numbers are consistent with the peak level of net government debt reaching 13 per cent of GDP.

Shadow treasurer Joe Hockey claimed there was a budget emergency and that the government ''has lost control of the budget'', whatever that means.

When it comes to economic management, the Coalition trumpets its credentials on the high-profile fact that under the Howard government, net government debt was eliminated. This is a terrific headline narrative, made even more remarkable by the fact that not only was debt eliminated, but the government accumulated net financial assets (negative net debt) of $45 billion, which was 3.8 per cent of GDP.

Very few countries have ever achieved negative net debt, which makes this result quite extraordinary. In one sense, it is very easy for a government to eliminate its debt when it was never all that large to begin with. When the Howard government won the 1996 election, net government debt stood at $96 billion, or 18.1 per cent of GDP.

When the Howard government left office, net government debt had ''improved'' by 21.9 per cent of GDP (from 18.1 to -3.8 per cent of GDP).

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So how did the Howard government do it? It was very simple, with a three-pronged approach to debt elimination:

■ A record high tax take - the Howard government was the highest taxing government in Australia's history.

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■ Record low spending on infrastructure - the level of public construction work done as a percentage of GDP reached a record low under Howard.

■ A large-scale asset sale and privatisation program.

It was a simple formula that worked a treat from a political objective, yet it had little merit as a tool of economic policy management.

Had the Howard government not had the highest tax take in history and simply maintained its tax take at the level of the Hawke/Keating government and nothing else changed, net debt would have risen, not fallen. The difference in the tax to GDP ratio under Howard versus Hawke/Keating was a cumulative 19.2 per cent of GDP over the life of the Howard government.

In other words, a record tax take from households and business accounted for the elimination of net debt.

The Howard government also embarked on a substantial program of asset sales. While many of these decisions to sell government assets were legitimate and, indeed, were sound, it was this simple transfer of ownership from the public sector to the private sector that further reduced debt.

Under the Howard government, asset sales and privatisations totalled about $74 billion in June 2008 dollar terms. This means that without asset sales, the Howard government would have left the incoming Rudd government net debt of $39 billion, or 3.7 per cent of GDP, rather than financial assets of $45 billion, or 3.8 per cent of GDP. Asset sales therefore accounted for 7.5 per cent of GDP of the reduction in net debt over the term of the Howard government.

This shows that the record tax take and the asset sales program accounted for 26.7 per cent of GDP, or the ''elimination'' of net debt of 18.1 per cent of GDP.

Figures from the Reserve Bank show that public construction work done as a percentage of GDP fell below 2 per cent, a record low, under the Howard government. This underspending on infrastructure may have helped the budget balance and debt reduction in the short term, but it occurred at a time when the RBA was exasperated at the inflationary effect of infrastructure bottlenecks that led to capacity constraints and declining productivity.

Road, rail and port facilities were at breaking point and inflation was unleashed. Indeed, by the time the Howard government left office, inflation was on track to reach a staggering 5 per cent, which was the highest inflation rate registered in the era of inflation targeting. This prompted the RBA to raise interest rates to 7.25 per cent as it battled to crimp the inflationary effect of what was chronic underinvestment in infrastructure.

Another point to note on the issue of the record of the Howard government in eliminating net government debt is the inconvenient fact that almost half the $96 billion Hawke/Keating Labor debt of 1996 was inherited by Hawke from the Fraser government during which time Howard was treasurer.

Indeed, net government debt was 7.5 per cent of GDP when the Hawke government came to power in 1983 and, for context, the Fraser government inherited zero net government debt from the Whitlam government. This means that all the government debt accumulation under the Fraser government was of its own making.

All of this can be seen in the assessment of Australia from the credit ratings agencies. It was only in 2011, when Fitch joined Moody's and Standard & Poor's with a triple-A rating with a stable outlook, that Australia was given the top rating from all three agencies.

The Howard government managed fiscal settings from a perspective of high tax and low infrastructure spending. This ensured net government debt was eliminated, but it frankly was no policy rocket science. Any government could eliminate debt in no time at all - just spend very little and collect a truck full of taxes, and voila! There you have it.

Not something a would-be government should want to hang its credentials on.

Stephen Koukoulas is a research fellow with the think tank Per Capita. Between September 2010 and July 2011, he was senior economic adviser to then prime minister Julia Gillard, having moved from a senior role in the Commonwealth Treasury.